25
Sep
Posted in Value Investing, basics by Roger |
When it comes to investing in stocks for capital gains, there are two different approaches that can be taken in order to ensure that your stocks increase their worth: growth investing and value investing. (There are other rationales for investing, such as investing for dividends, but for now let’s stick with growth and value investing.) These two methods represent two different ways of viewing stocks and trying to profit from them. So, what sort of considerations do you have to make when considering which method to use when choosing your investments?
Investing Rationales
Growth Rationale – The growth investor is looking for companies that growing their business (which you probably guessed). These could be small, upstart companies that have a great deal of potential, or large companies that continue to expand into new areas and increase their business at a much faster rate than their rivals. If stock investing were horse racing (a reasonably apt metaphor), growth stocks would be those that are the reigning champions or the quickly rising upstarts. The growth investing model essentially involves trying to find some of the fastest expanding companies, and tethering your fortunes to their growth.
Horse Racing - An Ideal Stock Metaphor
Value Rationale – Value investing, on the other hand, focuses on finding stocks that have been knocked below the true value of their respective companies, then buying and waiting for the broader market to recognize their worth. As with growth investing, these companies can be either large or small, and the reasons they are currently undervalued can be diverse: bad news that took the stock prize below a reasonable level, a run of bad luck that decreased the company’s perceived value, or even a broader economic storm that dragged everything down at once (like we’ve just experienced). To go back to our horse racing metaphor, value stocks would be akin to the strong finisher who’s failed to win the past several races and wound up as the long shot.
Why Does This Matter?
The difference between growth and value might seem academic, and in a way, it is. There are those people who have argued that assigning stocks to the ‘growth’ or ‘value’ columns have nothing to do with the actual value of the companies, but instead such dividers display their own ignorance. (’Those people’ in this case include Warren Buffet, as you can see at the bottom of this linked page, so perhaps they have a point.) On the other hand, when looking at the performance of broad segments of the US economy, it appears that the value investing style has beat out the growth style in the past.
The results, if you are a mutual fund investor (particularly a passive indexer like me), is that your portfolio should attempt to lean more towards value and less towards growth in terms of your funds’ orientation. This does not mean that every value stock will outperform every growth stock; on the contrary, because the faster increase in value of growth stocks is sometimes deserved, the top performers in the growth category can and will outperform the best of the value classification. Rather, it means that taken as a whole, stocks that are categorized as value will outperform those in the growth column over time. Unless you fancy being a stock picker (and make a good job of it, as well), sticking to a portfolio that leans toward value stocks will lead to a much richer future for you and yours.
I hope you enjoyed this rather brief introduction to value and growth stocks, as well as the difference between the two. Good luck with your investing, whichever option you decide to choose.
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1
Jul
Posted in Value Investing by Roger |
One of the major tools used by value investors to evaluate the companies they are considering is ratios. When evaluating the variety of financial information available for publicly traded companies, it’s helpful to use ratios for comparisons. Ratios allow you to make more accurate evaluations of different companies. If all you know is that two stocks have the same price, it’s hard to discern any useful information about their relative value; however, ratios like price-to-earnings and return on equity enable you to gain a deeper understanding of the company’s worth. Here are some of the most commonly used ratios, as well as the significance of each to investors:
Price-to-Earning (P/E): The ratio of the stock price divided by the earnings for the company, usually over the last twelve months. The P/E ratio is one of the most widely used, and is helpful in determining how ‘expensive’ a stock is; higher P/E values indicate more expensive stocks. Just what constitutes a high P/E value will vary depending on the particular type of stock, although a P/E value of around 15 is considered average for the S&P 500 index. The P/E ratio also tells you how long it will take for your investment to be returned, assuming the company’s earnings stay constant.
Earnings Yield (Price-to-Earnings): The ratio of earnings divided by the stock price, the inverse of the P/E. It’s called the earnings yield because it shows how much the stock earns for its price. This can be used to compare the effective rate of return for investing in that stock to the dividend yields offered by bonds. In the case of a stock with a P/E ratio of 15, the earnings yield would be 6.67%.
Current Ratio: The current assets of the company divided by the current liabilities. It’s useful in determining if the company can meet it’s current obligations. A closely related ratio is the quick ratio, where the inventory is subtracted from the current assets before the result is divided by the current liabilities. The quick ratio may be a more adequate indicator of the company’s ability to pay its debts, as some inventory can prove difficult to liquidate.
Return on Equity: The net earnings of the company divided by the owner’s equity. This is a measure of how much money the company returns to investors. Similar to the earnings yield, this ratio enables you to compare the return gained by investing in a given stock to other stocks as well as investments such as bonds.
These are just a few of the many ratios you can find or calculate while studying stocks for potential investments. Understanding the information that these ratios can provide and how to interpret it is vital to becoming a good value investor.
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30
Jun
Posted in Investing 101, Value Investing by Roger |
(As always, when it’s Tuesday, that means it’s time for another thrilling edition of Investing 101. This week, we’re going to look at something a little bit different, in this case, value investing. Rather than a single investment or set of investments, as with most of our Investing 101 columns, we’re going look at an entire investing philosophy. Given the sheer amount of depth in this subject, there’s no way I can cover everything about value investing in one post, or for that matter, even in a week. Although, this week will cover quite a bit of value investing basics; yesterday’s post on present and future value covered some of the calculations frequently used by value investors. And now, more of the basics of value investing.)
Q: What is value investing?
A: That’s a rather broad question, and one that’s difficult to answer. Value investing means different things to different people, and the variety of opinions sometimes leads to misunderstandings. In a nutshell, value investing requires looking at the intrinsic value of a company, and buy stock in the company as if you were buying the company itself.
Q: As if I were buying the company? What’s that supposed to mean?
A: Well, unlike technical investors or others who focus on stocks as entities separate from the underlying business, value investors evaluate the shares of stock they consider purchasing as, well, ’shares’ of the company they are considering. As a result, they look closely at the issuing company, evaluating its present state and future prospects, trying to determine how much the company is worth.
Q: How do you do that?
A: The most basic idea behind value investing is to calculate the intrinsic value of the company. By making some smart assumptions about how the earnings of the company will grow in the future, it’s possible to determine a reasonable estimate for how much the stock is worth in terms of future growth. It requires you to make assumptions (based on carefully considered research) on the future growth and run several calculations based on those numbers.
Q: That sounds kind of complex; are there any easier ways to run these calculations?
A: There are numerous online calculators that can be used to run intrinsic value calculations. One I particularly like comes from MoneyChimp. Or, if you prefer a more home made touch, I produced my own intrinsic value spreadsheet, based on the calculations listed in Value Investing For Dummies
.
Q: Wow, so all I do is plug numbers into these calculators, and they’ll tell whether I should buy these stocks or not?
A: In theory, yes. In practice, all intrinsic value calculations require you to make assumptions about how much the company value will grow in the future. As a result, the values you get are only as good as your assumptions. If you do plenty of research and come up with good values, you’ll likely have results that come close to reality. How you do that is the basis of value investing.
Hope that gives you a better understanding of value investing, as well as some tools to help you calculate the value of the stocks you in which you seek to invest.
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29
Jun
Posted in Value Investing by Roger |
Which would you rather have, fifty dollars now or one hundred dollars in the future?
If someone approached you on the street and asked you this, there would probably be a lot of questions running through your mind, like ‘Why do you want to give me money?’ and ‘Just who are you, anyway?’ If the offer turns out to be genuine, though, another question should come up, ‘When in the future would I get the hundred dollars?’ The value of one hundred dollars to you in the future will depend on how long in the future you need to wait in order to receive it. If you would get the hundred dollars next week, that’s a good deal; there aren’t any (legal, guaranteed) ways you could invest fifty dollars in order to double its value in seven days.
On the other hand, if you would receive the $100 in ten years, it would be a much wiser course to take the fifty dollars today. Not only could you safely invest the $50 in a way that it will be worth more than $100 in the future (barring any badly timed downturns), but the one hundred future dollars will not have the same spending power due to the effects of inflation.
This is known as the time value of money; inflation and potential investment gains make the same nominal amount of money more valuable in when received or spent in the present compared to the future. As a result, many financial advisers and planners will talk about future value, the worth of an investment after a set period of time has passed, and present value, the needed amount of money to invest currently to achieve that future value. The equation relating these values is:
FV = PV*(1+i)^n
Where FV is future value, PV is present value, i is the interest rate (which could be the rate of return, the inflation rate, or debt interest, depending on the calculation), and n is the number of years between the present and future values.
Confused? That’s understandable; let’s go through an example to see how all these numbers relate and show how we could calculate each of these values. In our example, you’re about to inherit a lump sum of money from the estate of your great-uncle Mort. After attending his funeral (and avoiding any completely unfunny comments about his name), you want to crunch some numbers to see if your inheritance alone will be enough to allow you to retire early in a few decades. You want to be able to set the inheritance money aside, allowing it to grow, and not have to invest anything more to fund your retirement.
You’re currently twenty-five, and would like to retire when you turn fifty, with twenty-five times your current income in savings (adjusted for inflation). That way, you think, you will be able to withdraw 4% each year, spend an (inflation-adjusted) amount equal to your current salary, and still have little chance of running low on money. If you earned $40k last year, you’re shooting for a total retirement fund of $1,000k (an even one million dollars) in present value to completely replace your salary at a 4% withdrawal rate. If you think there’s going to be a 4% inflation rate over the next few decades (a bit higher than the historic rate), the future value calculation will be:
FV = PV*(1+i)^n = $1,000k*(1+0.04)^25 = $1,000k*(2.772) = $2,772k
You will need $2,772k in order to replace your current income. Now, let’s assume that in order to achieve this investment goal, you plan to invest in bonds and bond funds, which you expect to return at least 6% throughout the next two and a half decades. We can rearrange our future value equation in order to determine what present investment value we need to get to this sum:
PV = FV/(1+i)^n = $2,772k/(1+0.06)^25 = $2,772k/4.292 = $646k
If good old Mort left you an inheritance of at least six hundred fifty thousand dollars, you’re sitting pretty; you can simply invest that money, and when you reach fifty, you can live off the proceeds without putting in another dollar towards your investments. But, to continue our explanation of future value (as well as remind you not to depend on old relatives dying to fund your retirement), let’s assume you didn’t get quite that much; if your inheritance was only $400k, it would take longer to reach your goal. To figure out how much longer, let’s solve the equation for n, using the same interest rate (be warned, we’re going to have to use natural logarithms to calculate n):
n = [ln(FV/PV)]/[ln(1+i)] = [ln($2,772k/$400k)]/[ln(1+0.06)] = [ln(6.93)]/[ln(1.06)] = 1.94/0.0583 = 33.2 years
If you’re willing to delay your retirement from fifty to fifty-eight, you can use your desired, very conservative investment plan, and still retire early by most people’s standards. If you want to keep your retirement at age fifty, though, you could add some stocks to your portfolio and increase your expected returns. To figure out just how much, we’ll solve for i in the final variation on our equation:
i = [(FV/PV)^(1/n)]-1 = [($2,772k/$400k)^(1/25)]-1 = [(6.93)^(0.04)]-1 = [1.081]-1 = 0.081 or 8.1%
Thus, to still build your money up fast enough to meet your retirement plans without adding more funds, you will need to average a return of 8.1% over twenty-five years. You can probably achieve this level of return if you’re willing to add some stocks to your asset mix; it will be tough to get enough of a return with just bonds (without taking on significant risk with junk bonds or similar riskier bonds). A good balanced fund will likely provide the level of return that you need.
Now of course, this is a simplified example, using only a single, large investment with compounding only once a year. If you put in small amounts into your investments on a regular basis, the calculations get trickier. Still, having an idea of what your investments will be worth when you cash them out or knowing what you need to invest in order to meet your goals is always a plus.
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